“The hedge fund guys are getting away with murder,” Republican presidential candidate Donald Trump said in an interview on the Sunday-morning news program Face the Nation. All of his potential Democratic opponents agree with this sentiment — not to mention members of his own party, like Jeb Bush.
What they are referring to is taxes paid on is what is commonly known as carried interest, that portion of a fund manager’s compensation based on the profits of the fund.
Common industry practice is to compensate portfolio managers by paying ongoing management fees based on the amount under management, usually 1 to 2 percent of assets, plus a share of the fund’s profits, typically 20 percent.
Ongoing management fees are taxed at standard corporate income tax rates, usually 39.8 percent. Income related to the carried interest generally retains the character of the underlying fund investments, much of which represents long-term capital gains, taxed at a lower rate of 23.5 percent.
This disparity in tax rates for seemingly similar activity is now in the bull’s-eye of both political parties. The question is no longer whether this disparity will end — but when and how.
The thrust of the criticism of the taxation of carried interest is twofold. First, carried interest is seldom taxable at the time it is granted, which is largely because carried interest only has value if profits are earned in the future and returns are difficult, if not impossible, to measure.
Second, as mentioned above, all or a portion of the compensation earned with respect to carried interest is treated as long-term capital gains, taxed at more favorable rates. Fund operators argue that carried interests are equity interests that should be treated no differently from the interests held by the fund’s investors.
Any comprehensive approach to changing the taxation of carried interest is likely to deal with both taxation of receipt of the interest and the tax character of profits earned with respect to it.
The latter may be easier to address. As is the case in the U.K., Congress could simply characterize all earnings as ordinary income, thus treating carried interest the same as fee income. Such a change is unlikely to discourage the use of carried interest, as there is an implicit tax deferral.
It is unclear how Congress will approach the deferral issue. In 2004 and 2008, Congress enacted IRS Code Sections 409A and 457A, respectively, to penalize taxpayers benefiting from most deferred compensation plans.
With few exceptions, those sections now impose additional taxes on distributions from nonqualified deferred compensation plans. A similar approach could be taken for carried interest, either through a similar provision or by extending the reach of Sections 409A and 457A.
The passive foreign investment company rules provide another guideline on how to tackle the issue of carried interest deferrals. Before the enactment of the PFIC, which passed Congress in 1986, investors in offshore funds could defer taxation of fund earnings until they received distributions or sold their holdings.
Gains on a sale were often treated as low-taxed capital gains. Under the PFIC rules, investors in offshore funds who sell or dispose of funds are either taxed at the time, generally at ordinary rates, or taxes can be deferred and they pay a penalty.
A similar approach could easily be applied to carried interest: Namely, managers could report annual increases in value on a mark-to-market basis or defer reporting at the cost of an eventual interest charge. In either case, the deferral implicit in carried interest will be affected.
Transition rules are likely to accompany any change in the taxation of carried interest, with possible impact ranging from grandfathering of existing carried interest at the time legislation is enacted to requiring that all carried interest becomes immediately taxable.
Once taxed, the question will be whether the interest is treated as an equity interest from that point forward or whether it produces ordinary income. It is worth noting that when Section 457A was enacted in 2008, previous deferred compensation would remain deferred for ten years but, from that point forward, would have tax liability.
Given what may be the inevitability of change, what should holders of carried interest consider for the time being? First, it is unlikely that Congress will enact any comprehensive tax legislation this year — and unlikely next year because of the upcoming election.
Second, any legislation in this area will alter the character of income earned with respect to carried interest. In anticipation of this, managers should consider the sale or redemption of their interest in 2015, before any legislation is enacted. Tax would be payable currently but most likely at lower rates. The after tax proceeds could then be reinvested in the fund.
Accordingly, we should not be surprised if new rules on carried interest come alongside extensive disclosure rules, with stiff penalties attached for noncompliance.
In recent years Congress has buttressed its attack on so-called abusive tax planning by imposing strong reporting requirements to force the disclosure of the targeted conduct. The rules for the disclosure of foreign assets held by U.S. citizens are a good example.
Investors should waste no time in thinking about the consequences of the demise of carried interest. When the time comes, alternatives will be available. As Bob Dylan sang, “You don’t need a weatherman to know which way the wind blows.”
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